Chapter 2: Introduction to Budget – Planning and Control
Budget: Planning, Control and Organizational Performance Among Public-Listed Companies in Malaysia
CHAPTER 2:
INTRODUCTION TO BUDGET PLANNING AND CONTROL
“Budgeting in a Company is like navigation in a ship. On the ship,
the crew keeps a log of the happenings on and the position of the ship
from hour to hour. The captain learns valuable lessons by studying
the factors that caused misadventures in the past. But, to pilot his ship
safely, he requires his navigation officer to plan the course ahead and
to constantly check the position of the ship against the plan. If the
ship is off-course, the navigation officer must report it immediately,
so that the captain can take prompt corrective action. In addition, the
navigation officer should be in a position to foresee possible obstacles
and deviations and to minimize losses by taking early corrective
action in case the ship is off-course.”
Just as a ship that needs to be navigated properly to reach its
destination safely, a Company needs a well-planned budget to help
achieve its goals. The ship’s log is like the previous budgets of the
Company. Just as the Captain refers to the log to learn valuable lessons
and avoid repeating mistakes, managers also use previous budgets to
help set benchmark in light of current business conditions. Planning
the ship’s course in advance helps the Captain to expect and identify
deviations from course and carry out salvage operations as early as
possible. In the same way, preparing a budget helps the Company to
meaningfully identify variances during the year.
(Axzo Press on Budgeting)
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2.1
DEFINITION
OF BUDGET,
BUDGETING
AND
BUDGETARY
CONTROL
The definition and interpretation of budget may differ among organizations, given
particular objective and purpose the budget was established in an organization and its
ensuant process. This section serves to clarify the perspective adopted by the author in
this research by defining the term budget, budgeting and budgetary control.
2.1.1 Budget
To begin, the definition from Chartered Institute of Management Accountants
(“CIMA”) Official Terminology is relevant. According to CIMA Official
Terminology, a budget is defined as “a quantitative statement for a defined period of
time, which may include planned revenues, assets, liabilities and cash flows. A budget
provides a focus for the organization, aids the co-ordination of activities and
facilitates control.”
To enhance understanding of the concept of budgets, the Australian National Institute
of Accountant (“NIA”) provides two different yet quite extensive definitions of
budget, offering different views on the purpose and form of a budget. The first
definition has a big approach, emphasizing on the budget as a management tool,
forming an integral and a necessary part of organizational stewardship. The second
definition has a more immediate, functional approach within the overall plan.
Definition 1: A budget is a comprehensive plan in writing, stated in monetary
terms, that outline the expected financial consequences of management’s plans and
strategies for accomplishing the organization’s mission for the coming period.
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Definition 2: A budget is a master financial document or a “blueprint for action”
that set out the expected contribution from the operation or control of an
organization in terms of anticipated cash flows or revenues and expected
expenditures over a certain period of time.
It can be observed from these two definitions by the NIA that a budget essentially is a
tool that forms part of the process of an effective management of an organization,
especially in planning and control. Budgets induce management to think
systematically and plan ahead about the future. They also serve as a device for
coordinating the complex operations of the business, and provide a medium for
communicating the financial goals of the firm.
There is also a simple definition of budget limiting its function only as a medium of
resource allocation. In reality, most organizations viewed budgets as a statement of
approved financial and operational resources allocated to each units, activities and
investments. Blumentritt (2006) explained that budgeting is the process of allocating
an organization’s available financial resources to its units, activities and investments
and to monitor the performance of managers and employees.
2.1.2 Budgeting
Budgeting, like any other activity, is subject to the interpretation of each practicing
organization. Budgeting is the process of preparation, implementation and operation
of budgets decisions into specific projected financial plans for relatively short periods
of time. In other words, budgeting is the process of “translating financial resources
into human purposes” (Wildavsky, 1986). Budgeting is also viewed as a process of
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Chapter 2: Introduction to Budget – Planning and Control
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identifying, gathering, summarising and communicating financial information of an
organization’s future activities. Blumentritt (2006) further explained that budgeting
processes include a review and study of the prior period’s financial results,
projections for sales, operating expenses (fixed, variable, and semi-variable) and
financing expenses, examination of proposals for capital expenditures, and means of
rolling up and rationalizing figures from different functional departments to ensure
they meet company-wide profit expectations.
2.1.3 Budgetary Control
Dutta in his book titled “Management Control System” enunciates that budgetary
control is a systematic and formalised approach for accomplishing the planning,
coordination and control responsibilities of management. Merchant and Van der Stede
(2003) agreed that budgetary control is a central device of management control. The
use of budgets to control a firm’s activities is known as budgetary controls (Garrison
and Noreen, 1997).
Budgetary control is defined by CIMA as “the establishment of budgets relating the
responsibilities of executives to the requirements of a policy, and the continuous
comparison of actual with budgeted results, either to secure by individual action the
objective of that policy, or to provide a basis for its revision”. Budgetary control is a
system of controlling costs and resources which includes comparing actual
performance with the budgeted performance and subsequently acting upon the actual
results to minimise variance and achieve maximum returns. In essence, budgetary
control is purported to ensure that the activities carried out are providing the desired
results.
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In this paper, the following definitions are adopted:
•
Budget: refers to a comprehensive plan in writing, stated in monetary terms, that
outline the expected financial consequences of management’s plans and
strategies for accomplishing the organization’s mission for the coming period.
•
Budgeting: refers to the process of preparation, implementation and operation of
budgets decisions into specific projected financial plans.
•
Budgetary control: refers to any management approach that involves setting
some kind of targets, regularly measuring variances between the original targets
and actual outcomes, and motivating people to reduce those variances.
2.2
CHARACTERISTICS OF BUDGET
As stated earlier, a budget is a blueprint for management action. The following are the
common features of budget:
•
A budget is quantitatively stated: The figures in the budget are expressed in
monetary terms. However, the monetary figures are supported by non-monetary
information such as units to be sold, units to be purchased and others.
•
A budget is prepared in advance: A budget must be drawn up before the period
to which it refers. Figures produced during or after the period may be important,
but they are not part of a budget.
•
A budget relates to a particular period: Generally, the budget is prepared for
one year. However, in the case of a seasonal business, there may be two budgets
for each year – a slack season budget and a peak season budget.
•
A budget is a plan of action: A budget is a plan because it concerns actions to
be taken rather than a passive acceptance of future trends. Planning is the
establishment of objectives and the formulation, evaluation and selection of the
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policies, strategies, tactics and action required to achieve the objectives. Like all
plans, budgets seldom turn out to be totally correct predictions of the future.
Conditions may change during the budget period, which renders the budget to be
inaccurate. Even so, budget is useful in guiding the actions of managers.
•
A budget is an estimation or prediction of profit potential: The budget set forth
the expenses and revenues planned during the budget period and thereby reveals
its profit potential.
2.3
BUDGET AND ITS ROLES
A budget, if created and used properly, can provide valuable information about the
direction, resources and expectations of the organisation. Budget is described as an
integral part of management control systems that aims at promoting coordination and
communication among subunits within the company, provides a framework for
judging performance and finally motivating managers and other employees (Horngren
et al, 2005).
The idea of multiple uses of budgets in organizations is not new. To serve as an
effective tool, budget pursues different tasks such as planning, forecasting,
controlling, coordinating, communicating, instructing, authorizing, motivating,
delegating, educating, evaluating performance, facilitating decision making and
managing subordinates. Hansen and Van der Stede (2004) has explored many sources,
either from the perspective of management accounting and control textbooks,
academic research and practice, to generate a list of why organisations adopted
budgets, particularly on its purpose and roles. They contended that each source creates
a slightly different list, and it is difficult to determine the best list.
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Emmanuel, Otley and Merchant (1999) in their book on “Accounting for Management
Control” explained that budget can act in different roles in organisations. Some
possible roles involve budgets being used as a:
•
Means of Forecasting and Planning: One of the functions served by most
budgets is that of forecasting and planning. Forecasting refers to the prediction of
events over which the organisation has little or no control of while planning is the
attempt to shape the future by altering those uncontrollable factors in the light of
available forecasts. Given a set of forecast, the budget model is able to operate in
an optimising role, attempting to ascertain which plan of action will result in the
greatest benefit of the organisation.
Since planning is at the heart of a budgeting process, by employing the
budgeting process diligently, companies can plan extensively on the best course of
action to achieve the organization’s goals. As a planning aid, budgets allows for
the refinement and quantification of the long-term business plan into short-term
action plans whereby alternative planning scenarios may be examined and a
“what-if” analysis applied. Without the annual budgeting process, the pressures of
day-today operating problems may tempt managers not to plan for future
operations (Drury, 2001). The budgeting process encourages managers to
anticipate problems before they arise, and hasty decisions that are made on the
spur of the moment, based on expediency rather than reasoned judgement, will be
minimised (Drury, 2001).
•
System for Authorisation: The responsibility of each manager is made amply
clear as the budget would usually describe the amount of resources and degree of
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Chapter 2: Introduction to Budget – Planning and Control
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authority managers need and have to achieve the organization’s goals. Thus,
budgets serve as a formal authorisation for a manager to spend a given amount of
money on specific activities. In this respect, budgets is used to ensure that
organisational resources is utilised in the most productive and profitable way, to
achieve efficiency required for the business operations thereby reducing costs and
raising profitability (Australian Society of CPA, 1999). Such a system of
authorisation must be supported by a suitable responsibility structure adopted by
the organization
•
Channel for Communication and Coordination: Evidently, budgets are an
important channel of communicating certain type of information that will enable
managers in different parts of the organisation to be fully informed of the plan and
policies, and constraints, to which the organisation is expected to conform.
Through the budgeting process, top management communicates its expectations to
the lower level management, so that members of the organisation may understand
these expectations and can coordinate their activities to attain them (Drury, 2001).
In essence, preparation of the budgets facilitates the transfer of vital information
among all levels in the organisation and thus, level of interaction are more
enhance during the budgeting process.
The co-ordination of business activities will be aided through the budgeting
process. Considering that all actions of the different parts of the organisation are
brought together and reconciled into a common plan, the budgeting process assist
to bind an organisation together towards the achievement the organisation’s goal.
Without any guidance, managers may each make their own decisions, believing
that they are working in the best interest of the organisation (Drury, 2001).
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Budgeting compels managers to examine the interrelationships and dependency
among different parts of the organisation, and in the process, to identify and
resolve conflicts.
•
Motivational Device: The budget can be a useful device for influencing
managerial behavior and motivating managers to perform in line with the
organizational objectives (Drury, 2001). A budget provides a standard that under a
certain circumstances may motivate managers to strive to achieve the standard.
However, it is possible for manager to view the budget as a pressure device in
trying to get them to achieve a level of performance that they do not see as
achievable. Nevertheless, motivation would be enhanced through the feeling of
involvement which participation in the budgeting process can promote. If
individuals have actively participated in preparing the budget, and it is used as a
tool to assist managers in managing their units, budget can act as a strong
motivational device by providing a challenge (Drury, 2001).
•
Means of Performance Evaluation and Control: A budget assists managers in
managing and controlling the activities for which they are responsible. The control
of business activities may be aided through the comparison and quantitative
measurement of actual results against the budget plan. By doing this, managers
can ascertain which activities do not conform to the original plan and require their
attention. By investigating the reasons for the deviations, managers may be able to
identify inefficiencies (Drury, 2001). Hence, appropriate control and corrective
action can be taken to remedy the situation (Drury, 2001).
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A budget is basically a yardstick against which actual performance is
measured and assessed. Thus, a manager’s performance is often evaluated by
measuring his or her performance in meeting the budgets. In view of this, budget
thus provides a useful means of informing managers of how well they are
performing in meeting targets that they have previously helped to set (Drury,
2001).
2.4
THE BUDGET PLANNING AND CONTROL PROCESS
As implied in the definitions provided above on budgets, budgeting and budgetary
control, it can be seen that budget planning and control are virtually inseparable
functions. Through numerical statement of plans and breaking of these plans into
components consistent with the organization structure, budgets force and correlate
planning and allow authority to be delegated without loss of control.
Budget setting is a process, not a specific formula or technique. Thus, understanding
the intricacies and the dynamics of the budgeting process is essential. Budgeting is an
iterative cycle which moves between targets of desirable performance and estimates
of feasible performance until there is a convergence of plan which is feasible and
acceptable (Emmanuel, Otley and Merchant, 1990). It usually starts with a forecast of
future fundamental performance such as sales and net profits. A forecast is a
prediction of future events and their quantification is used for the purpose of planning.
A forecast relates to events in the environment over which the business has either no
control or limited control. Budgeting process also involves the issuance of guidelines
by top management, interaction among various departments, strategy analysis,
preparation of preliminary budgets, review by departmental/business unit heads,
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Chapter 2: Introduction to Budget – Planning and Control
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negotiation with top management, finalisation of each budget, preparation of the
master budget and lastly, their approval by the top management. The following
diagram gives a brief summary of a very complex process:
Figure 2.1: The complete budgeting process
The organization’s objectives
PLANNING
Strategy
Short-term aims
Forecast
Budget
CONTROL
Budgeted results in line with short-term aims?
Yes
No
Implement budget
Revise budget
Monitor budget
Actual results in-line with budget?
Yes
No
Investigate and take corrective action
Source: Association of Accounting Technicians, London
The budget construction process will normally follow the organizational
structure. The budgets process provides a system for coordinated planning among
different functional areas (Ramsey and Ramsey, 1985; Bremser, 1988). Some
organizations follow a top-down, or mandated approach. Others utilize a bottom-up
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Chapter 2: Introduction to Budget – Planning and Control
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approach which is closely related to the participative philosophy of budgeting. The
description of each budget construction process are as follows:
•
Top-down Budget: Also known as “Imposed Budget”, this approach to
budgeting will begin with upper level management establishing parameters
under which the budget is to be prepared. Lower-level managers have very
little, if any, input into the determination of the budget amount and setting the
overall goals of the organization. The lower-level units involvement in the
process are essentially reduced to doing the basic budget calculations and
adhering to the directives of top management.
One disadvantage of the top-down approach is that lower-level managers
may view the budget as a dictatorial standard. Resentment can be fostered in
such an environment. Further, such budgets can sometimes provide ethical
challenges, as lower-level managers may find themselves put in a position of
ever-reaching to attain unrealistic targets for their units. On the positive side,
top-down budgets can set a tone for the organization. Top management can
ensure that the budgets are aligned with the strategic plans. The budgeting
process can be completed faster as less time is needed for budget administration.
•
Bottom-up Budget: Bottom-up budgeting is also known as “Participatory
Budget” mainly due to the nature and degree of lower-level managers’
involvement in the formulation of budget. Top management may initiate the
budget process with general budget guidelines, but essentially bottom-up
budgeting begins at the operational level. The operational units drive the
development of budgets for their units. These individual budgets are then
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Chapter 2: Introduction to Budget – Planning and Control
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grouped and regrouped to form a divisional budget with mid-level executives
adding their input along the way. Eventually top management and the budget
committee will receive the overall plan. The budget committee reviewed the
budget components for consistency and coordination. This type of budgeting
requires more time to move through the process and complete the budget, but
ensures buy-in and commitment at all levels of the company.
•
Blended Approach: Blended approach is a combination of top-down and
bottom-up budget process whereby in this process, top management sets
objectives for financial performance and submits these to operating managers,
who then develop budgets based on these objectives. The budget is reviewed by
top management and either approved, disapproved, or revised. The process may
require several iterations of passing the budget back down the ladder for
revision by operational units until a final budget is reached.
The blended approach to budgeting is also known as “Negotiated Budget”.
Negotiation in budgeting process will cause subordinates to behave more cooperatively. Thus, it follows that subordinates’ will have less incentive to build
slack in their budget target which they are trying to negotiate and are more
committed in transforming the plans into actions once approved by the top
management. Blended approach is best suited for a company with a certain
amount of sophistication in preparing budgets.
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2.5
TYPE OF BUDGETS
The end product of a budgeting process is a master budget. The master budget
summarises the objectives of all subunits of an organization. It quantifies the
expectation regarding the future income, the financial position, cash flows and
supporting plans. Cohen, Robbins and Young (1994) divided the master budgets into
two primary components; operating budget and financial budget which is further
described below. For more details on the different types of operating and financial
budgets, refer to Appendix 1.
•
Operating Budget: Operating budget consists of plans for all those incomegenerating activities that makes up the normal operations of the organization.
The main components of an organization’s operating budgets are sales,
production,
inventory,
materials,
labour,
overhead and research and
development budgets.
•
Financial budget: Financial budget is used to control the financial aspects of
the business. In effect, it reveals the influence of the operating budgets on the
financial position of the organization and its earnings potential at end of the
budget period. They include a cash budget, capital expenditure budget and proforma balance sheet and income statement.
The following figure shows how the different types of budgets as described above are
connected within the larger system of the master budget. This illustration confirmed
that each individual budget is dependent on one another, whereby during the
preparation of budget, one cannot proceed further if the pre-requisite budget is not
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Chapter 2: Introduction to Budget – Planning and Control
Budget: Planning, Control and Organizational Performance Among Public-Listed Companies in Malaysia
prepared. Thus, budgeting process is a systematic process, which shall be conducted
in sequential and hierarchical manner.
Figure 2.2: Major budgets and their relationship
Finished
goods stock
budget
Production
budget
Production
overhead
budget
Direct labor
budget
Material usage
budget
Purchases
budget
Creditors
budget
Selling and
distribution costs
budget
Sales
budget
Administration
costs budget
Debtors
budget
Cash budget
Research &
development
budget
Master
budget
Capital
expenditure
budget
Source: Banovic, 2005.
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